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Special Kentucky Derby Report: Abnormal Returns and Extreme Leverage

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[Although not strictly a financial event, the Kentucky Derby is a favorite among many hedge fund traders who are constantly on the look-out for for uncorrelated returns and exposure to hidden upsides. It's actually a bit surprising that more of Greenwich's royalty haven't gone into the horse racing business yet. We asked John Carney to file this report on the Derby.]
I sat on the back porch of my parents' Westchester home watching my forearms turn pink in the spring sun. It was the first Saturday in May and the house was full of guests for the annual Kentucky Derby party. Beside me, on a slight wicker chair my mother had purchased at an auction in the Catskills, sat Katherine, her restless legs stretching out from within her Tory Burch tennis whites, talking about how she financed the sixth-year of her undergraduate education. I closed my eyes and felt the heat of the sun against their lids, and smelled the bourbon and mint and burnt nicotine in the air.
“I raffled off a motorcycle. A 1946 Indian. A real classic. The tickets were beautiful. Works of art really. Each had a full color picture of the Indian, and the picture was taken in the badlands of South Dakota. There was not a man alive who wouldn’t see himself riding through that weird landscape past herds of semi-wild buffalo toward a rally in Stirges. We sold close to two thousand tickets, at five dollars a piece,” Katherine said.
“Fantastic. Where did you get the bike?” I asked.
“You have too little imagination, John. There was no bike. There never was a bike. Or, rather, the bike exists, the picture was real, but I never had such a beautiful thing to raffle off.”
“Weren’t you worried you would get caught?”
“I never worry about such things. Who could catch me? Only the winner. He was the only injured party, and the only person who needed to be told that he could not have the bike. I gave him his five dollars back, and thus made him whole. What else could he ask for? This drink is fantastic, by the way.”

I had declined the mint juleps, on the grounds that they had too much sugar for anyone raised north of the Mason-Dixon line to tolerate. So we were drinking a cocktail of my own invention. It was simply a dry gin-and-tonic with a bit of mint crushed into the bottom of the glass. It was to the northern shore of the Long Island Sound what a mint julep is to Kentucky or a Mojito is to Cuba.
“Glad you like it,” I replied. Before settling on these, we had tried to match the day with various drinks. And when I say various drinks I am giving away the Rosetta Stone of my life. “How do you have the nerve for your scams?”
“I have a secret defense—I am interested in life.”
“Of course. So am I, but…”
“You are interested in a person, not in life. What is the phrase? ‘A respecter of men.’ And people leave us—they die, they graduate, they move to Los Angeles. Our search for divinity runs aground the shitty little mortality of others. In short, other people are a constant disappointment. I am interested in the greenness of mint, and sharpness of tonic. Every drink ends with an empty glass or half-melted ice but I have discovered the immortality of life itself, of creation, if you will.”
It almost goes without saying but I will say it anyway: for the last few years Katherine has worked for a multi-strategy hedge fund. The fund founded by three liberal arts majors who have since hired nothing but quants. Katherine being the sole exception to this rule, as she is to almost every other rule I have ever come across.
Katherine shook her empty glass. I took the glass from her hand and walked into the house. Behind the bar was Danny Red, a huge boulder of a man who had been serving drinks at this party for a dozen years. He poured me a pair of the drinks. “I’m thinking of calling these Stingers. After the things that wasps have,” he said.
In the next room the gamblers were lined up to place bets with my brothers, Brian and Tim, who play the bookies of the party. Brian calculated the odds on lap-top computer, and Tim took the bets and handed the bettor a slip of paper with numbers indicating the size of the bet, the number of the horse and the win-place-or-show outcome. Although this was a social event, the guests took the placing of bets very seriously. Even more so the collection of their winnings when they picked the right horse. I did not envy my brother this task.
My responsibility at the party was much simpler. I ran the pools. There were two five-dollar pools and two two-dollar pools. The lettered tickets were sold by pretty girls as the guests passed through the Doric columns at the top of the front steps to my parents' house. You didn’t know which horse you were going to get but the odds were good: for a five-dollar ticket you stood to win one hundred dollars in a twenty horse race. And for most people, betting blind was not much more of a handicap than betting ignorantly on a horse they chose. (This is a pattern familiar to anyone who has compared the results of choosing stocks by throwing darts at a dartboard and choosing stocks by following the advice of Wall Street’s brightest analysts.) After all the tickets were sold, we revealed which letters corresponded to which horses.
I held the money after the tickets were sold and before the race was run. It amounted to two-hundred and sixty dollars. I watched the bets being placed, and thought about Katherine and about Katherine’s legs and about the way Katherine always had money but never worked for it. Someday she would marry someone fabulously rich and then he would die and she would spend years in court battling his progeny from his first marriage, and each day in court she would wear a different, stunning outfit. This was one fate for her, but I was beginning to imagine others.
I cooled my throat with the mint-blanched gin and walked in front of the betting table. “I will take two hundred and sixty dollars on Street Sense to win,” I told Tim. Street Sense had been picked by CNBC’s Erin Burnett the day before as her favorite for the derby, presumably because the name was so much like her show “Street Signs.” More importantly, the Wall Street Journal's By The Numbers columnist had explained that Street Sense was the only horse running who had been a runner-up in one of the four preparatory races run in the month or so before the Derby: he Florida Derby, Arkansas Derby, Santa Anita Derby, Blue Grass Stakes or Wood Memorial. Apparently, it’s a losing bet to bet on the winners of those races but a winning bet to bet on the losers. The soundness of this jujitsu logic was completely persuasive after five Stingers.
My brother looked at me incredulously. He knew where the money I was betting had come from. “This is what is called leverage,” I told him. “Simple financial leverage. I owe this money, true, but those debts don’t come due until the race is won. At which point I will have won far more from you. You will learn this if you ever go to business school.”
He scribbled the numbers on my ticket beside a large W. I didn’t tell Tim the other thing I knew. I had bought a pool ticket with the letter ‘O’ which turned out to be the ticket for Street Sense. I was placing all my eggs in one basket, counting my chickens before they hatched, preferring the dozen in the bush to the one in hand. I had no hedge to fund, no multi to my strategy. The wisdom of the world was against me.
I won’t try to build suspense about the race because everyone knows who won on Saturday, with Street Sense surging ahead over the sloppy track and beating out pacesetter and early leader Hard Spun. For the first minute of the race, Street Sense was in 19th place. If there had been a margin call at that point, I would have lost everything. Less than a minute later, with Street Sense sliding up along the rail then pushing outside and ahead of Hard Spun to cross the finish line first, I felt like a genius. Or, at least, like someone who had just called the direction of natural gas prices correctly. It was a good race, and I had made a good bet. The odds were good and my leveraged gamble put a good piece of cash into my pockets.
After the race I looked for Katherine to tell her how things had turned out. The spot on the porch where we had spent the afternoon was taken by Dan Red and his sister, busily chatting about a guest who had been discovered passed-out in the bathroom. Katherine had already left with a few of the other guests for late dinner party in Manhattan. She had left a note with the simple message: “Congrats on your winning. Sorry I had to run. xoxoxo--Kat.” I couldn’t help but feel I had lost a different kind of wager. Despite my daring bet, I was still a respecter of persons.
A Loser's Game [Wall Street Journal]
Street Sense Wins Kentucky Derby [Wall Street Journal]